Investors who put their pennies in Coinbase could get pinched

In its April stock market debut, Coinbase, which runs the largest U.S. exchange for bitcoin and other private digital currencies, made a very big splash. It closed its first day of trading at $328.28 a share, putting its market capitalization at $85 billion—more than 10 times what it was valued at in its previous fundraising round.

Its stock fell shortly thereafter, in part because a series of ransomware attacks raised worries that cryptocurrencies could end up in regulators’ crosshairs, pushing the price of bitcoin lower. At $256.77 Coinbase still doesn’t look particularly cheap, trading at 31 times expected earnings, which compares with a forward price-to-earnings ratio of 26 for Nasdaq and 23 for Intercontinental Exchange.

Of course it is possible that Coinbase’s business will grow very quickly, in which case its lofty valuation might be more than justified. But considering the wild swings in price and popularity that bitcoin and other cryptocurrencies have undergone, that is no sure thing. Nor is it operating in a world without competition: There are dozens of crypto exchanges vying with one another. To hang onto its market share, Coinbase might need to reduce the transaction fees it charges for trades, and from which it continues to draw the bulk of its revenues.

The bigger risk, however, is that many authorities worry that cryptocurrencies are unduly dangerous. Beyond helping to enable ransomware attacks and other criminal activities, the lack of regulatory oversight worries officials such as Securities and Exchange Commission Chairman Gary Gensler, who has called crypto the “Wild West.” In May, Federal Reserve governor Lael Brainard, who is seen as a candidate for the top spot at the central bank if President Biden chooses not to renominate Chairman Jerome Powell, warned that “predominance of private moneys may introduce consumer protection and financial stability risks because of their potential volatility and the risk of run-like behavior.”

The Fed, like other central banks, also is exploring the possibility of issuing a digital dollar and is expected to soon issue a discussion paper on the subject. Some of the arguments for doing so include the possibility of faster settlements, reducing money-transfer costs and providing the unbanked with better access to the financial system. It also could dampen demand for crypto alternatives—something that Fed officials may see as a feature rather than a bug.

“I think that’s one of the arguments that are offered in favor of a digital currency, that particularly you wouldn’t need stable coins, you wouldn’t need cryptocurrency if you had a digital U.S. currency,” Mr. Powell said before Congress last month. “I think that’s one of the stronger arguments in its favor.”

It all sets the stage for what could be a trying period for cryptocurrencies, and by extension, Coinbase. The infrastructure bill making its way through Congress includes a provision to toughen tax enforcement of crypto transactions. Regulators may also start making more noise. In addition to the Fed and SEC, Karen Petrou, who runs policy-analysis firm Federal Financial Analytics, believes that an array of regulatory agencies, including the Consumer Financial Protection Bureau, the Financial Stability Oversight Council and the Office of the Comptroller of the Currency could step into the fray.

It might be that in the end regulators ultimately stay their hands, the Fed deems a digital currency unworkable and that Coinbase’s business flourishes as a result. But first it might have to run through the gantlet, and investors would be better off not running with it.